The million dollar question

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What returns should I expect from my investments?

Easy question, difficult answer. A lot of books and many, many column inches have been taken up debating that one.

Of course, the most defensible answer is “no-one knows for sure”, but this isn’t helpful. For financial planning we need a forecast to start from and we can and should do better than shrug our shoulders and say no-one knows. Pension providers are required to prepare forecasts for us, it helps to understand how these have been prepared.

These forecasts are literally the million dollar question as many people now saving into pension schemes from early in their career could expect to accumulate million dollar (or pound) pension assets without winning the lottery (see here).

Million dollar questions: Numbers below assume a starting salary of 25,000 age 21, with 18% savings and either 5% [1] or 7% [2] annual investment returns. Inflation is 2.5% per year and real salary rises are 2% above inflation.

As part of a research project with interactive investor I recently went right down the rabbit hole on the topic of investment growth forecasts, the piece is a worth a read in its entirety even if I do say so myself, but here are five key takeaways.

1. Inflation

One key issue for all investors to grapple with is the effect of inflation. Numbers far into the future might look big, but a large part of that is due to inflation and you shouldn’t let that fool you. What you should concern yourself with are real returns over and above the level of inflation, as this is what really grows your wealth over time.

Frustratingly, it’s not always clear from provider forecasts and literature whether returns are being quoted in “real” (after inflation) or nominal terms and this is more than a technicality, it really matters.

Current forecasts for credible providers such as academics, banks and asset managers point to real returns from stock markets of 3-5% per year (5-7% total returns).

2. Lower for longer

It will surprise no-one to hear that interest rates are low, but it’s important to bear in mind this also pulls down the future reutrns on all sorts of other asset classes. This means that while stock markets have historically given us real returns of around 7% per year (10% total) in the past,

this is unlikely to be the case in the future and we do need to modify our expectations. It’s clear to see that forecasts have fallen a lot even over the last decade, so something you reviewed a few years ago may be out of date now.

Interestingly – and this surprised me – based on a survey done by interactive investor of 2,600 customers in the UK, expectations of future total returns are actually in a pretty good place on average (about 60% of people expecting 5-7%p.a.) albeit with significant tails at both ends being either too optimistic or too pessimistic, both of which have issues.

3. What’s under the hood?

We’ve talked a lot here about stock market (equity) returns as that is the asset class more than any other that is going to deliver decent real returns for you over the longer term moreso now than ever with the low and negative real returns coming from most bond investments.

It is worth taking a look under the hood of your investments as many “balanced” investment approaches might be designed to address a more risk-averse investor, or simply not had their allocations reviewed in a few years and so place a significant minority of assets in lower returning bonds, pulling down your overall returns. The best advice is to seek independent advice to understand your risk tolerance but a simple rule is that if you are very early in your career you can and should have the vast majority of your assets invested in stocks.

4. Charges matter

One thing that can be relied upon in investing is the charges you pay: to the asset manager, platform provider and adviser. These can easily add up to 2% per year which might not sound much but takes a huge bite out of the sort of real return numbers we mentioned above.

This is particularly acute when you take into account the double-whammy of the lower return environment we’re in, and lower risk balanced funds. High charges on low risk funds is one of the worst combinations around as you are almost guaranteeting yourself to lose money. Our research shows that on a typical lower risk balanced funds, charges could eat up 60% of all the growth your money generates.

5. Time

When your investing, compounding really matters, and what we see is a huge part of our investment growth in dollar or pound terms is likely to take place after age 60. It’s enitrely possible that half of your age-70 assets could have been accrued between age 60 and 70. This makes retirement date crucial, and probably goes to show that it needs to be later than what our parents were accustomed to (which, to be honest, hardly changed from what their parents were used to) and also ideally to stay flexible, to give our savings the best chance of growing to where they need to get to.

Illustratation as above: saving from age 21 at 17% of earnings. Starting salary 25,000 inflation 2.5%, real wage increases 2% per year. Investment returns 5% and 7% annually, charges 0.48%

the Age of Responsiblity, but the Industry needs to step up

A big shift over recent decades is the burden of responsiblity moving to the individual more than the employer or the state to fund retirement, hence why I say: we’re all investors now. You can paint this negatively as an impending crisis or (as I do) choose to view it more positively as millions of people being empowered to take charge of their own financial future. The industry needs to massively step up and help these people, not by trying to flog them another fund or bury charges deep in the jargon, but providing simple, jargon free calculators and guides to help them understand the long-term growth of assets, something which is not-at-all intuitive even to those who have worked in the industry for a long time

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